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There’s a Reason for Deposit Insurance

FOR all the criticism of bailouts since the financial crisis struck, virtually no one has suggested that depositors in banks be made to suffer along with their investors, employees and customers. Until this week, when the euro zone proposed that, in return for a bailout of the failing banking system in Cyprus, depositors pay a “tax” of 6.75 percent of their deposits — 9.9 percent for deposits above 100,000 euros.

Because bank deposits in Cyprus, and virtually everywhere, are insured, the plan shocked many people who figured that this insurance was the one financial safety net that was still truly “safe.”

The Cypriot Parliament shot down the plan, though a smaller hit to depositors — many of whom are wealthy foreigners — was still in the offing late last week. Yet the tempest in the eastern Mediterranean is a reminder that depositors, in fact, are also creditors of banks and are potentially at risk.

In the United States, deposit insurance is viewed as sacrosanct. But even here, such plans haven’t always worked, and at least until recent times they have been contentious.

If the nation has a father of bank insurance, it is Joshua Forman, one of the promoters of the Erie Canal. Early in the 19th century, New York State had a string of bank failures, and Martin Van Buren, then governor, asked him to restructure the banking industry. Forman’s insight was that banks were vulnerable to chain-reaction panics. As he put it — in a line unearthed by the Harvard Business School historian David Moss — “banks constitute a system, being peculiarly sensitive to one another’s operations, and not a mere aggregate of free agents.”

In 1829, Forman proposed an insurance fund capitalized by mandatory contributions from the state’s banks. Debate in the State Assembly was heated. Critics said failures could overwhelm the fund; they also argued that its very existence would reduce the “public scrutiny and watchfulness” that restrained bankers from reckless lending. This remains the intellectual argument against insurance today. But Forman’s plan was enacted, and subsequently five other states adopted plans.

Photo

A bank run in New York in 1907. The financial turmoil in Cyprus has been a reminder that depositors are creditors of banks and can thus be at risk.Credit
George Grantham Bain Collection/Library of Congress

All did not go smoothly. In the 1840s, during a national depression, 11 banks in New York State failed and the insurance fund — as prophesied — was threatened with insolvency. The state sold bonds to bail it out.

After the Civil War and the establishment of nationally chartered banks, the state insurance systems were allowed to die. But banking panics and money shortages in the 1870s and ’80s revived the issue. Republicans thought the way to stop panics was to establish a central bank. Democrats were inveterate central-bank haters, but they needed a solution. William Jennings Bryan, the party’s three-time presidential nominee, called for deposit insurance, especially to protect small depositors.

Bryan lost the elections, but he won a victory of sorts on insurance. In 1907, a Wall Street panic led to a depression, and banks nationwide resorted to doling out scrip rather than cash. With the economy still in free-fall, Oklahoma adopted deposit insurance. Republicans were hotly opposed. President William Howard Taft, running against Bryan for president in 1908, said the Oklahoma law “put a premium on reckless banking.” The industry predicted that the system would fail. Depositors, argued James Laughlin, a banking expert of the day, should rely on the “skill, integrity and good management” of bankers.

Oklahomans thought otherwise. So great was the demand for insurance that Oklahoma banks with national charters liquidated and reorganized as state banks to participate. In fact, people in neighboring Kansas began to deposit in Oklahoma, forcing Kansas to enact a similar plan. Ultimately, eight states adopted insurance.

Their experience, alas, bore out the critics’ warnings. Depressed farm prices led to waves of bank failures in the 1920s, and one by one state systems folded.

When bank failures reached epidemic proportions in the Great Depression, the idea was revived. Again, the industry opposed it — as did Franklin D. Roosevelt, who said insurance “would lead to laxity in bank management and carelessness on the part of both banker and depositor.” Insurance was to be financed by premiums from banks. Still, because it was guaranteed by the government, Roosevelt feared that it could bankrupt the Treasury.

Photo

A line at an A.T.M. in Nicosia, Cyprus, last week.Credit
Andreas Manolis/Reuters

But popular opinion prevailed. The Federal Deposit Insurance Corporation was created in 1933, protecting deposits up to $2,500. Over time, the insured limit rose to $100,000. (And it more than doubled, to $250,000, in the recent crisis.)

The system worked — for a while. In the 1970s, finance was deregulated, interest rates turned volatile and savings and loan associations (protected by another agency) took huge risks. Hundreds of S.& L.’s failed, and their insurer became insolvent. Taxpayers had to fork over more than $100 billion.

To critics, the S.& L. fiasco proved that insurance was a flawed concept. The problem wasn’t insurance per se, but that premiums weren’t high enough — nor were they adjusted according to the risk presented by individual banks. (By the same principle, any rational auto insurer will charge a higher premium for an 18-year-old with a D.U.I.)

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INCREDIBLY, Congress didn’t learn its lesson. After recovery from the S.& L. crisis, Congress, lulled by an improving climate, succumbed to bankers who called the F.D.I.C. overfinanced. Premiums were cut to zero for banks judged to be well capitalized.

Again, the good times didn’t last. In 2009, in the financial crisis, the F.D.I.C. fund was underwater. Net assets — $53 billion before the crash — fell to a negative $21 billion. The agency crawled back into the black by ordering banks to pay premiums in advance and by leveling a special assessment. In 2010, the Dodd-Frank law raised premiums, especially for bigger banks and for banks classified as riskier. No taxpayer money was used.

The F.D.I.C.’s deficit amounted to a failure of foresight, or courage, by Congress, but the system succeeded in the larger sense of heading off panics. Just imagine the crisis in confidence in 2008 had ordinary depositors feared for their money. Insurance proved to be worth its weight in gold.

Cyprus, alas, does not have the option of a national government bailout because it does not print its own money. Even if it rejects the euro zone’s terms and bails out banks in some new local currency, that currency would not be worth much in international markets. So one way or another, its depositors are going to lose. Insurance plans are just as safe — but cannot be any safer — than the assets behind them.

Roger Lowenstein is writing a book on the origins of the Federal Reserve.

A version of this article appears in print on March 24, 2013, on Page BU3 of the New York edition with the headline: There’s A Reason
For Deposit
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